Here’s how value investing works.

The S&P 500 lost 0.8% on the week, including 1.9% on Friday, and is now sitting on the 20-day moving average. Further downside testing is likely. The 200-day moving average is at 2755 and may be challenged sometime this week. 

The big news last week, of course, was the Federal Reserve’s surprising dovishness. Not only didn’t the Fed hike at the recently concluded FOMC meeting, which wasn’t expected anyway, but it sent a strong signal that rate hikes are off the table for 2019. The Fed Fund Futures market responded by ratcheting up the likelihood of a rate cut by December from just 30% the week prior to 58%, according to the CME Group’s FedWatch site. Bond yields dropped sharply on the news with the U.S. 10-year ending the week at 2.46%. The German and Japanese 10-years are negative once again, something thought impossible before the great recession and financial crisis of 2008. In fact, there is still an estimated $10 trillion in negative yielding debt around the world. Clearly, times are not normal and the financial system is still high-risk. Furthermore, the U.S. yield curve has now inverted with 3-month Treasury bills yielding more than the 10-year Treasury. An inverted yield curve is a reliable recession indicator, although not a very good timing device. Yield curves can remain inverted for extend periods of time, up to 18 months, before a recession materializes. 

There was additional negative fundamental news last week as well. The IHS Markit PMI manufacturing index fell to 52.5 in March from 53 in February, below expectations of 53.6. It’s the lowest reading in 21 months and included weaker new orders - a leading indicator. As well, Euro-zone manufacturing activity dropped sharply and Japanese manufacturers are struggling also. Meanwhile the slow-down in China, the world’s second largest economy, continues. On the other hand, the Conference Board Leading Economic Index (LEI) increased for the first time in five months, although only marginally. But perhaps most importantly for the near-term direction of the U.S. stock market, U.S. corporate earnings reports will begin in April. The expectation is for a 3.6% decline in corporate earnings, the first decline since Q2 2016.

We’ve been expecting a sizeable retracement of the now 3-month rally off the December lows. How the S&P 500 responds to the coming earnings season will give us a much better insight as to whether our expectation will be met.

Too many investors confuse investing in stocks with investing in stock markets. A stock is part ownership in an underlying business. Businesses can be valued. We all want to buy things when they’re on sale at the grocery store but for some reason many of us don’t think about buying part ownership in a business when it’s on sale. On the contrary, it’s estimated that only about 10% of investors worldwide are contrarians looking to buy a business that’s on sale. Everyone else seems to want to buy stocks that have already gone up because, hey, they’re going up!

Here’s how value investing works…

We started buying General Mills for clients between $44 and $46 last fall. The stock had been as high as 72 back in 2016. We had fair value at $54-$55 per share. GIS was paying $1.96 in dividends in 2018 for a yield of around 4.3% and is expected to pay $1.98 in 2019. We were fortunate to be able to buy more for many clients in the high 30s during the September – December melt down, with some clients ending with an average cost below $40 per share. General Mills is a good, albeit slow, growing company, which recently bought Blue Buffalo, a faster growing pet food maker. Consumer staples is considered a defensive sector because people have to eat (and feed their pets) regardless of the economy. The stock is a low volatility play as well with a beta of only 0.75, according to Value Line.

Today the stock is at $50.74. We expect it to reach $55 per share within the next few years. Here’s how the math shakes out for our ownership in GIS for the entire two to three year holding period (typical for our style of investing). Purchased at $45 and sold at $55 gives us a capital gain of 22.2%. Collecting two years of dividends adds another 8.8% for a total return of 31% over two years, or 15.5% annually. The long run return for the U.S. stock market is between 9% and 10% annually and with more risk (volatility). Of course, our investors that have a cost basis below $45 will earn even more. Remember, it’s not a stock market but a market of stocks, as Benjamin Graham liked to say.

Regards,

Christopher R Norwood, CFA

Chief Investment Advisor